Principal-Protected Notes - 09/04/02
U.S. equity markets over the past two years have experienced their steepest losses in decades, and a great many personal portfolios have suffered significant losses. As a consequence, we have seen an explosion of new products which help manage risk. Most notably, observes the Merrill Lynch/Cap Gemini ?World Wealth Report,? several specialized investment products ?are becoming increasingly important to high net worth investors.? These products offer some key potential benefits to high net worth investors in terms of performance and risk management, and ?constitute a growing market that any player serving high net worth individuals would be wise to incorporate? into their offerings.
The ?World Wealth Report? identifies two classes of specialized investment products being offered by the more far-sighted financial institutions: (1) structured products, like principal-protected notes (PPNs), which are designed to produce some significant market upside while minimizing risk, and (2) alternative investments, like hedge funds, which tend to generate higher average returns with less correlation to market swings and so can play a key role in risk-diversification strategies.
A PPN behaves like a bond whose return is tied or ?linked? to the performance of an underlying investment. Returns can be linked to a particular index such as the S&P 500 Index, linked to a more narrowly focused ?sector? stock index or to a pool of investments with varied investment strategies, such as a portfolio of hedge funds with diversified strategies. The notes are usually issued and principally guaranteed by a world-class financial institution which carries high, investment grade credit ratings from both Standard & Poor?s and Moody?s. From a risk perspective, the investor has effectively transferred the risk of his investment from the underlying investment to the credit risk of the guaranteeing financial institution.
PPNs enables investors the best of both worlds ? the return potential of the underlying investments combined with absolute protection of principal. While the terms of each PPN varies, collectively they offer these benefits to investors:
? Growth potential. The value of PPNs is tied to the performance of particular investments, offering investors upside participation in these potential growth opportunities.
? Preservation of capital. Issuers of PPNs promise to return, at a minimum, your original investment at maturity, regardless of market performance.
? Credit rating. Issuers of PPNs are rated in the highest credit rating categories available.
? Diversification. Because of their link to a particular index or type of investment, such as hedge funds, they can be used to further diversify an existing portfolio mix of stocks, bonds, mutual funds and cash.
? Low minimum investment. Minimum investments can be lower than if directly investing in the underlying investment vehicles.
? Liquidity. Certain PPNs offer weekly liquidity although the underlying investments generally require longer holding periods.
Stocks, as well as hedge funds with broad-based strategies, have amply rewarded investors for their participation over the long-term; however, some investors are still reluctant to take on their potential risks. Since such investments provide one of the best wealth-building investments over time, these individuals may be missing an opportunity to benefit. There is a way to invest for long-term growth, with a degree of safety that could help calm market jitters. PPNs achieve this goal, and are particularly suited for those investors who wish to participate in the upside potential of the markets, while limiting exposure to the downside, have access to hedge funds or other investment vehicles in a risk-controlled manner and potentially earn higher investment returns with fixed income-like risk.
PPNs are for investors who would like to participate in the growth potential of the underlying markets, whether stocks, indexes or hedge fund strategies, for example, but are concerned about the possibility of losing some or all of their initial investment. PPNs offer the potential of attractive returns, with the added benefit of principal protection if held to maturity.
APPENDIX (assumes PPN linked to a fund of hedge funds)
Hedge funds versus mutual funds
The differences between hedge funds versus mutual funds are that hedge funds are not regulated, while mutual funds are regulated in the U.S. (under the Investment Company Act of 1940.) Additionally, hedge funds may sell stocks short and use leverage, whereas mutual funds generally can not do either.
Hedge fund strategies
The more than 6,000 hedge funds of the world, representing some $700 billion of invested capital, have many strategies. They may be categorized as follows:
? Convertible Bond Arbitrage & Volatility Arbitrage ? Includes the arbitrage of convertible bonds with the underlying stocks, and the arbitrage of options versus the underlying indices.
? CTA & Global Macro ? Includes the trend following of Commodity Trading Advisors, long term and short term, and systematic and discretionary; usually using exchange-traded futures. Also includes the trading of major, global underlying asset classes such as currencies or interest rates.
? Event Driven & Risk Arbitrage ? Usually reflecting an opportunistic approach, includes merger arbitrage and special situations, such as index arbitrage, warrant arbitrage, capital structure arbitrage, major corporate restructurings, spin-offs, self-tenders, bankruptcies, distressed debt, etc.
? Financial Instrument Arbitrage ? Includes the arbitrage of mortgage-backed securities, as well as convergence trading.
? Long/Short Equity ? sub-strategies include market neutral, long bias, short bias, small cap, large cap, growth, value, U.S., international, etc.
Performance of Hedge Funds Versus Stocks
Whereas investments in stocks entail directional risk, i.e., the buyer is hoping the price will go up, hedge funds usually implement an absolute return or relative value investment strategy which attempts to generate positive returns in nearly any kind of market environment. Below are recent performance statistics of U.S. stocks, as represented by the S&P 500 Index, and the net returns of hedge funds, as represented by the CSFB/Tremont Hedge Fund Index, which is an asset weighted index of all hedge funds, regardless of strategy, within their TASS data base, based off of 2,600 funds which meet certain eligibility requirements (size, audit, etc.).
Index Hedge Funds
2002 YTD thru July -20.60% -0.03%
2001 -13.04% 4.42%
2000 -10.14% 4.85%
1999 19.53% 23.43%
1998 26.67% -0.36%
1997 31.01% 25.94%
1996 20.26% 22.22%
1995 34.11% 21.69%
1994 -1.54% -4.36%
There is a cost to PPNs, substantially reflected by the absence of current, periodic dividend or interest payments. While the costs may vary widely, and are determined by many factors, including the current interest rate environment, the all-in cost is generally in the range of 2%-4% per annum. This includes the guarantee fee, investment advisory fee and administrative fees. Consequently, the investor is generally sacrificing current income for the opportunity to have more significant upside potential, and yet the peace of mind of knowing that his capital is 100% protected.